While the commercial and residential investment sectors share some common characteristics, there are several important distinctions between them as well. Specifically, an investor should expect significant differences between the levels of risk, return, income, and capital needed in residential vs. commercial real estate.
To start, let's first define residential real estate and commercial real estate and then dive into what to expect when investing in these two asset classes, including specifics on how to obtain loan approval.
What is residential real estate?
Residential real estate has between one and four units and includes:
Families and individuals typically lease these properties (as opposed to businesses). Residential real estate involves finding tenants to live in these properties, and, after tenants move into the apartment or house, they pay rent to the owner each month. When screening tenants for a residential unit, the landlord should review the prospective tenant's previous rental history, credit, income, and various other details about their background to ensure they will be responsible, long-term tenants who will care for the property.
Marketing to longer-term renters decreases tenant turnover, causing less stress for the landlord. Long-term renters are more likely to treat a rental as if it were their own home, maintaining the property and general upkeep. These types of renters provide a steady financial income to investors, as well.
What is commercial real estate?
Commercial real estate properties are those with five or more units or any property used for business (as opposed to residential) purposes. This includes:
Businesses and corporations typically tend to lease commercial properties, and a commercial lease agreement is used when securing tenants. Lease agreements tend to be more complicated at the commercial level and can include absolute net leases, triple net leases, modified gross net leases, and full-service leases.
Pros of investing in residential real estate
Property management tends to be easier
Depending on the situation, owning residential property tends to be less cumbersome at the residential level. Managing a single tenant, couple, or household can be far more manageable than managing a warehouse or apartment complex with hundreds of tenants. Depending on how many residential properties the landlord owns, it may not be necessary to hire a property manager to handle the assets. Rent collection and maintenance and repairs can be handled by the landlord directly. Of course, if the investor owns several residential properties, this may be difficult to manage independently, and a property manager may be necessary.
Whether you own a residential or commercial property, landlords reap several tax benefits when they invest in real estate. Those who own property with tenants can deduct expenses associated with home repairs and improvements, rental income, mortgage interest, property management costs, and depreciation.
Cons of investing in residential real estate
Frequent tenant turnover
Residential leases can range from 12 months, 24 months, or a fixed term of 90 days to a month-to-month contract with no end date. Tenants in residential leases tend to be families, friends, roommates, and individuals. Because residential real estate typically involves renting someone their primary home, there is an emotional element involved in residential investing that isn't as common in the commercial sector.
On the flip side, commercial property is typically leased to businesses and tends to be more transactional than emotional. Additionally, because families and individuals tend to rent residential property, those who are only on six- or 12-month leases might not be as inclined to care for the property. In contrast, tenants who sign longer-term leases tend to respect the property and its rules a bit more.
Residential real estate investing pros and cons